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CARF-F-240

Collateralization and CVA

Masaaki Fujii

The University of Tokyo

Akihiko Takahashi

The University of Tokyo

Current Version: February 2011

Mutual Life Insurance Company, Meiji Yasuda Life Insurance Company, Nippon Life Insurance

Company, Nomura Holdings, Inc. and Sumitomo Mitsui Banking Corporation (in alphabetical

order). This financial support enables us to issue CARF Working Papers.

http://www.carf.e.u-tokyo.ac.jp/workingpaper/index.cgi

Working Papers are a series of manuscripts in their draft form. They are not intended for

circulation or distribution except as indicated by the author. For that reason Working Papers may

not be reproduced or distributed without the written consent of the author.

Derivative Pricing under Asymmetric and Imperfect

Collateralization and CVA ∗

Masaaki Fujii†, Akihiko Takahashi‡

Current version: February 15, 2011

Abstract

The importance of collateralization through the change of funding cost is now well

recognized among practitioners. In this article, we have extended the previous stud-

ies of collateralized derivative pricing to more generic situation, that is asymmetric

and imperfect collateralization as well as the associated CVA. We have presented ap-

proximate expressions for various cases using Gateaux derivative which allow straight-

forward numerical analysis. Numerical examples for CCS (cross currency swap) and

IRS (interest rate swap) with asymmetric collateralization were also provided. They

clearly show the practical relevance of sophisticated collateral management for finan-

cial firms. The valuation and the associated issue of collateral cost under the one-way

CSA (unilateral collateralization), which is common when SSA (sovereign, suprana-

tional and agency) entities are involved, have been also studied. We have also discussed

some generic implications of asymmetric collateralization for netting and resolution of

information.

Keywords : swap, collateral, derivatives, Libor, currency, OIS, EONIA, Fed-Fund, CCS,

basis, risk management, HJM, FX option, CSA, CVA, term structure, SSA, one-way CSA

∗

This research is supported by CARF (Center for Advanced Research in Finance) and the global

COE program “The research and training center for new development in mathematics.” All the contents

expressed in this research are solely those of the authors and do not represent any views or opinions of

any institutions. The authors are not responsible or liable in any manner for any losses and/or damages

caused by the use of any contents in this research.

†

Graduate School of Economics, The University of Tokyo

‡

Graduate School of Economics, The University of Tokyo

1

1 Introduction

In the last decade, collateralization has experienced dramatic increase in the derivative

market. According to the ISDA survey [11], the percentage of trade volume subject to

collateral agreements in the OTC (over-the-counter) market has now become 70%, which

was merely 30% in 2003. If we focus on large broker-dealers and the ﬁxed income market,

the coverage goes up even higher to 84%. Stringent collateral management is also a crucial

issue for successful installation of CCP (central clearing parties).

Despite its long history in the ﬁnancial market as well as its critical role in the risk

management, it is only after the explosion of Libor-OIS spread following the collapse of

Lehman Brothers that the eﬀects of collateralization on derivative pricing have started to

gather strong attention among practitioners. In most of the existing literatures, collat-

eral cost has been neglected, and only its reduction of counterparty exposure have been

considered. The work of Johannes & Sundaresan (2007) [12] was the ﬁrst focusing on the

cost of collateral, which studied its eﬀects on swap rates based on empirical analysis. As

a more recent work, Piterbarg (2010) [13] discussed the general option pricing using the

similar formula to take the collateral cost into account.

In a series of works of Fujii, Shimada & Takahashi (2009) [7, 8] and Fujii & Takahashi

(2010,2011) [9, 10], modeling of interest rate term structures under collateralization has

been studied, where cash collateral is assumed to be posted continuously and hence the

remaining counterparty credit risk is negligibly small. In these works, it was found that

there exists a direct link between the cost of collateral and CCS (cross currency swap)

spreads. In fact, one cannot neglect the cost of collateral to make the whole system

consistent with CCS markets, or equivalently with FX forwards. Making use of this

relation, we have also shown the signiﬁcance of a ”cheapest-to-deliver” (CTD) option

implicitly embedded in a collateral agreement in Fujii & Takahashi (2011) [10].

The previous works have assumed bilateral and symmetric collateralization, where the

two parties post the same currency or choose the optimal one from the same set of eligible

currencies. Although symmetric collateral agreement is widely used, asymmetric situation

can also arise in the actual market. If there is signiﬁcant diﬀerence in credit qualities

between two parties, the relevant CSA (credit support annex, specifying all the details

of collateral agreements) may specify asymmetric collateral treatments, such as unilateral

collateralization and asymmetric collateral thresholds. Especially, when SSA(sovereign,

supranational and agency) clients are involved, one-way CSA is quite common: SSA enti-

ties refuse to post collateral but require it from the counterpart ﬁnancial ﬁrms. One-way

CSA is now becoming a hot issue among practitioners [14]. Since the ﬁnancial ﬁrm needs

to enter two-way CSA (or bilateral collateralization) to hedge the position in ﬁnancial

market, there appears a signiﬁcant cash-ﬂow mismatch. In addition, as we will see later,

the ﬁnancial ﬁrm may suﬀer from the signiﬁcant loss of mark-to-market value due to the

rising cost of collateral.

Asymmetric collateralization, even if the details speciﬁed in CSA are symmetric, may

also arise eﬀectively due to the diﬀerent level of sophistication of collateral management

between the two parties. For example, one party can only post single currency due to

the lack of easy access to foreign currency pools or ﬂexible operational system while the

other chooses the cheapest currency each time it posts collateral. It should be also impor-

tant to understand the change of CVA (credit value adjustment) under collateralization.

2

Although, it is reasonable in normal situations to assume most of the credit exposure is

eliminated by collateralization for standard products, such as interest rate swaps, preparing

for credit exposure arising from the deviation from the perfect collateral coverage should

be very important for the risk management, particularly for complex path-dependent con-

tracts, for which it is unlikely to achieve complete price agreements between the two

parties.

This work has extended the previous research to the more generic situations, that is

asymmetric and imperfect collateralization. The formula for the associated CVA is also

derived. We have examined a generic framework which allows asymmetry in a collateral

agreement and also imperfect collateralization, and then shown that the resultant pricing

formula is quite similar to the one appearing in the work of Duﬃe & Huang (1996) [3]. Al-

though the exact solution is diﬃcult to obtain, Gateaux derivative allows us to get approx-

imate pricing formula for all the cases in the uniﬁed way. In order to see the quantitative

impacts, we have studied IRS (interest rate swap) and CCS with an asymmetric collateral

agreement. We have shown the practical signiﬁcance for both cases, which clearly shows

the relevance of sophisticated collateral management for all the ﬁnancial ﬁrms. Those

carrying out optimal collateral strategy can enjoy signiﬁcant funding beneﬁt, while the

others incapable of doing so will have to pay unnecessary expensive cost. We also found

the importance of cost of collateral for the evaluation of CVA. The present value of future

credit exposure can be meaningfully modiﬁed due to the change of eﬀective discounting

rate, and can be also aﬀected by the possible dependency between the collateral coverage

ratio and the counter party exposure. There also appear a new contribution called CCA

(collateral cost adjustment) that purely represents the adjustment of collateral cost due

to the deviation from the perfect collateralization.

After the collapse of Lehman Brothers, investors have been suﬀering from the loss of

transparency of prices provided by broker-dealers, each of them quotes quite diﬀerent bids

and oﬀers. This is mainly because the ﬁnancial ﬁrms started to pay more attention to

counter party credit risk and also because there was no consensus for the proper method

of discounting of future cash ﬂows for secured contracts with collateral agreements. How-

ever, the situation is now changing. Recently, SwapClear of LCH.Clearnet group, which

is one of the largest clearing house in the world, started to use OIS (overnight index

swap) curve to discount the future cash ﬂows of swaps. This is one of the examples that

the market benchmark quotes for the standardized products are converging to the per-

fectly collateralized ones with standard symmetric CSA. We also think that this should be

the only possible way to achieve enough price transparency, since otherwise we need the

portfolio and counterparty speciﬁc adjustment. Our formulation is based on the above un-

derstanding and derives CCA and CVA as a deviation from the collateralized benchmark

price, which should be useful for practitioners who are required clear explanation for each

additional charge to their clients.

We have also discussed some interesting implications for ﬁnancial ﬁrm’s behavior under

(almost) perfect collateralization. One observes that the strong incentives for advanced

ﬁnancial ﬁrms to exploit funding beneﬁt may reduce overall netting opportunities in the

market, which can be a worrisome issue for the reduction of the systemic risk in the market.

3

2 Generic Formulation

In this section, we consider the generic pricing formula. As an extension from the previous

works, we allow asymmetric and/or imperfect collateralization with bilateral default risk.

We basically follow the setup in Duﬃe & Huang (1996) [3] and extend it so that we can

deal with cost of collateral explicitly. The approximate pricing formulas that allow simple

analytic treatment are derived by Gateaux derivatives.

2.1.1 Setup

We consider a ﬁltered probability space (Ω, F, F, Q), where F = {Ft : t ≥ 0} is sub-σ-

algebra of F satisfying the usual conditions. Here, Q is the spot martingale measure, where

the money market account is being used as the numeraire. We consider two counterparties,

which are denoted by party 1 and party 2. We model the stochastic default time of party i

(i ∈ {1, 2}) as an F-stopping time τ i ∈ [0, ∞], which are assumed to be totally inaccessible.

We introduce, for each i, the default indicator function, Hti = 1{τ i ≤t} , a stochastic process

that is equal to one if party i has defaulted, and zero otherwise. The default time of

any ﬁnancial contract between the two parties is deﬁned as τ = τ 1 ∧ τ 2 , the minimum

of τ 1 and τ 2 . The corresponding default indicator function of the contract is denoted by

Ht = 1{τ ≤t} . The Doob-Meyer theorem implies the existence of the unique decomposition

as H i = Ai + M i , where Ai is a predictable and right-continuous (it is continuous indeed,

since we assume total inaccessibility of default time), increasing process with Ai0 = 0,

and M i is a Q-martingale. In the following, we also assume the absolute continuity of Ai

and the existence of progressively measurable non-negative process hi , usually called the

hazard rate of counterparty i, such that

∫ t

i

At = his 1{τ i >s} ds, t≥0. (2.1)

0

For simplicity we also assume that there is no simultaneous default with positive proba-

bility and hence the hazard rate for Ht is given by ht = h1t + h2t on the set of {τ > t}.

We assume collateralization by cash which works in the following way: if the party

i (∈ {1, 2}) has negative mark-to-market, it has to post the cash collateral 1 to the counter

party j (̸= i), where the coverage ratio of the exposure is denoted by δti ∈ R+ . We assume

the margin call and settlement occur instantly. Party j is then a collateral receiver and

has to pay collateral rate cit on the posted amount of collateral, which is δti × (|mark-

to-market|), to the party i. This is done continuously until the end of the contract. A

common practice in the market is to set cit as the time-t value of overnight (ON) rate of

the collateral currency used by the party i. We emphasize that it is crucially important

to distinguish the ON rate ci from the theoretical risk-free rate of the same currency ri ,

where both of them are progressively measurable. The distinction is necessarily for the

uniﬁed treatment of diﬀerent collaterals and for the consistency with cross currency basis

spreads, or equivalently FX forwards in the market (See, Sec. 6.4 and Ref. [10] for details.).

1

According to the ISDA survey [11], more than 80% of collateral being used is cash. If there is a liquid

repo or security-lending market, we may also carry out similar formulation with proper adjustments of its

funding cost.

4

We consider the assumption of continuous collateralization is a reasonable proxy of

the current market where daily (even intra-day) margin call is becoming popular. We

are mainly interested in well-collateralized situation where δti ≃ 1, however, we do also

include the under- as well as over-collateralized cases, in which we have δti < 1 and δti > 1,

respectively. Although it may look slightly odd to include the δti ̸= 1 case under the con-

tinuous assumption at ﬁrst sight, we think that allowing under- and over-collateralization

makes the model more realistic considering the possible price dispute between the rele-

vant parties, which is particularly the case for exotic derivatives. Most of the long dated

exotics, such as PRDC and CMS-related products, contain path-dependent knock-out or

early redemption triggers, which makes the sizable price disagreements between the two

parties almost inevitable. Because of the model uncertainty, the price reconciliation is

usually done in ad-hoc way, say taking an average of each party’s quote. As a result,

even after the each margin settlement, there always remains sizable discrepancy between

the collateral value and the model implied fair value of the portfolio. Therefore, even in

the presence of timely margining, the inclusion of generic collateral coverage ration taking

value bigger or smaller than 1 should be important for portfolios containing exotics.

Under the assumption, the remaining credit exposure of the party i to the party j at

time t is given by

where Vti denotes the mark-to-market value of the contract from the view point of party

i. The second term corresponds to the over-collateralization, where the party i can only

recover the fraction of overly posted collateral when party j defaults. We denote the

recovery rate of the party j, when it defaults at time t, by the progressively measurable

process Rtj ∈ [0, 1]. Thus, the recovery value that the party i receives can be written as

( )

Rtj max(1 − δtj , 0) max(Vti , 0) + max(δti − 1, 0) max(−Vti , 0) . (2.2)

As for notations, we will use a bracket ”( )” when we specify type of currency, such as

(i) (i)

rt and ct , the risk-free and the collateral rates of currency (i), in order to distinguish it

(i,j)

from that of counter party. We also denote a spot FX at time t by fxt that is the price

of a unit amount of currency (j) in terms of currency (i). We assume all the technical

conditions for integrability are satisﬁed throughout this paper.

We consider the ex-dividend price at time t of a generic ﬁnancial contract made between

the party 1 and 2, whose maturity is set as T (> t). We consider the valuation from the

view point of party 1, and deﬁne the cumulative dividend Dt that is the total receipt from

party 2 subtracted by the total payment from party 1. We denote the contract value as

St and deﬁne St = 0 for τ ≤ t. See Ref.[3] for the technical details about the regularity

conditions which guarantee the existence and uniqueness of St . Under these assumptions

5

and the setup give in Sec.2.1.1, one obtains

[∫

{ ( ) }

St = βt E Q βu−1 1{τ >u} dDu + yu1 δu1 1{Su <0} + yu2 δu2 1{Su ≥0} Su du

]t,T ]

∫ ]

( )

+ βu−1 1{τ ≥u} Z 1 (u, Su− )dHu1 + Z 2 (u, Su− )dHu2 Ft , (2.3)

]t,T ]

on the set of {τ > t}. Here, y i = ri − ci denotes a spread between the risk-free and

collateral rates of the currency used by party i, which represents the instantaneous return

from the collateral being posted, i i

(∫ i.e. it)earns r but subtracted by c as the payment to

t

the collateral payer. βt = exp 0 ru du is a money market account for the currency on

which St is deﬁned. Z i is the recovery payment from the view point of the party 1 at the

time of default of party i (∈ {1, 2}):

( ) ( )

Z 1 (t, v) = 1 − (1 − Rt1 )(1 − δt1 )+ v1{v<0} + 1 + (1 − Rt1 )(δt2 − 1)+ v1{v≥0} (2.4)

( ) ( )

Z 2 (t, v) = 1 − (1 − Rt2 )(1 − δt2 )+ v1{v≥0} + 1 + (1 − Rt2 )(δt1 − 1)+ v1{v<0} , (2.5)

where X + denotes max(X, 0). Note that the above deﬁnition is consistent with the setup

in Sec.2.1.1. The surviving party loses money if the received collateral from the defaulted

party is not enough or if the posted collateral to the defaulted party exceeds the fair

contract value.

Even if we explicitly take the cost of collateral into account, it is possible to prove the

following proposition about the pre-default value of the contract in completely parallel

fashion with the one given in [3]:

Proposition 1 Suppose a generic financial contract between the party 1 and 2, of which

cumulative dividend at time t is denoted by Dt from the view point of the party 1. Assume

that the contract is continuously collateralized by cash where the coverage ratio of the party

i (∈ {1, 2})’s exposure is denoted by δti ∈ R+ . The collateral receiver has to pay collateral

rate denoted by cit on the amount of collateral posted by party i, which is not necessarily

equal to the risk-free rate of the same currency, rti . The fractional recovery rate Rti ∈ [0, 1]

is assumed for the under- as well as over-collateralized exposure. For the both parties,

totally inaccessible default is assumed, and the hazard rate process of party i is denoted by

hit . We assume there is no simultaneous default of the party 1 and 2, almost surely. Then,

the pre-default value Vt of the contract from the view point of party 1 is given by

[∫ ( ∫ s ) ]

( )

Vt = E Q exp − ru − µ(u, Vu ) du dDs Ft , t ≤ T (2.6)

]t,T ] t

where

( )

µ(t, v) = yt1 δt1 − (1 − Rt1 )(1 − δt1 )+ h1t + (1 − Rt2 )(δt1 − 1)+ h2t 1{v<0}

( )

+ yt2 δt2 − (1 − Rt2 )(1 − δt2 )+ h2t + (1 − Rt1 )(δt2 − 1)+ h1t 1{v≥0} (2.7)

if the jump of V at the time of default (= τ ) is zero almost surely, and then satisfies

St = Vt 1{τ >t} for all t. Here, St is defined in Eq. (2.3).

6

See Appendix A for proof. One important point regarding to this result is the fact

that we can actually determine y i almost uniquely from the information of cross currency

market. This point will be discussed in Sec. 6.4. In the reminder of the paper, we assume

that there is no price jump in V at the time of default, which seems reasonable assumption

at least for standard derivatives on interest rates and foreign exchange rates. Notice that,

since we assume totally inaccessible default time, there is no contribution from pre-ﬁxed

lump-sum coupon payments to ∆Vτ .

3 Symmetric Collateralization

Let us deﬁne

ỹti = δti yti − (1 − Rti )(1 − δti )+ hit + (1 − Rtj )(δti − 1)+ hjt , (3.1)

where i, j ∈ {1, 2} and j ̸= i. In the case of ỹt1 = ỹt2 = ỹt , we have µ(t, Vt ) = ỹt that is

independent from the contract value Vt . Therefore, from Proposition 1, we have

[∫ ( ∫ s ) ]

Vt = E Q

exp − (ru − ỹu )du dDs Ft . (3.2)

]t,T ] t

value in a standard way. Now, let us consider some important examples of symmetric and

perfect collateralization where (y 1 = y 2 ) and (δ 1 = δ 2 = 1). One can easily conﬁrm that

all the following results are consistent with those given in Refs. [7, 8, 10, 9].

Case 1: Situation where both parties use the same collateral currency ”(i)”, which is the

same as the payment currency. In this case, the pre-default value of the contract in terms

of currency (i) is given by

[∫ ( ∫ s ) ]

(i) Q(i)

Vt = E exp − cu du dDs Ft ,

(i)

(3.3)

]t,T ] t

Case 2: Situation where both parties use the same collateral currency ”(k)”, which is

the diﬀerent from the payment currency ”(i)”. In this case, the pre-default value of the

contract in terms of currency (i) is given by

[∫ ( ∫ s ) ]

( )

(i) (i)

Vt = E Q exp − c(i) + y (i,k)

du dD s Ft , (3.4)

]t,T ] t

u u

( ) ( (k) )

= ru(i) − c(i)

u − ru − c(k)

u . (3.6)

Case 3: Situation where the payment currency is (i) and both parties optimally choose

a currency from a common set of eligible collaterals denoted by C in each time they post

7

collateral. In this case,

[∫ ( ∫ s ) ]

( (i) )

(i) Q(i)

Vt =E exp − cu + max yu(i,k) du dDs Ft (3.7)

]t,T ] t k∈C

gives the pre-default value of the contract in terms of currency (i). Note that collateral

payer chooses currency (k) that maximizes the eﬀective discounting rate in order to reduce

the mark-to-market loss. This is also the currency with the cheapest funding cost. See

Sec. 6.4 and its Remark for details.

Remark: Notice that we have recovered linearity of each payment on the pre-default value

for all these cases. In fact, in the case of symmetric collateralization, we can value the

portfolio by adding the contribution from each trade/payment separately. This point can

be considered as a good advantage of symmetric collateralization for practical use, since it

makes agreement among ﬁnancial ﬁrms easier as the transparent benchmark price in the

market.

We now consider more generic cases. When ỹt1 ̸= ỹt2 , we have non-linearity (called semi-

linear in particular) in eﬀective discounting rate R(t, Vt ) = rt − µ(t, Vt ). Although it is

possible to get solution by solving PDE in principle, it will soon become infeasible as the

underlying dimension increases. Even if we adopt a very simple dynamic model, usual

”reset advance pay arrear” conventions easily make the issue very complicated to handle.

For practical and feasible analysis, we use Gateaux derivative that was introduced in

Duﬃe & Huang [3] to study the eﬀects of default-spread asymmetry. We can follow the

same procedure by appropriately redeﬁning the variables. Since evaluation is straightfor-

ward in a symmetric case, the expansion of the pre-default value around the symmetric

limit allows us simple analytic and/or numerical treatment. Firstly, let us deﬁne the

spread process:

η̃ti,j = ỹti − ỹtj . (4.1)

Then, under an assumption that ỹ i and ỹ j do not depend on V directly, the ﬁrst-order

eﬀect on the pre-default value due to the non-zero spread appears as the following Gateaux

derivative (See, Ref. [5] for details.):

[∫ T ]

∫ ( ) 2,1

− ts (ru −ỹu

max −Vs (0), 0 η̃s ds Ft ,

2 )du

∇Vt (0; η̃ ) = E

2,1 Q

e (4.2)

t

where Vt (0) is the pre-default value of contract at time t with the limit of η̃ 2,1 ≡ 0 and

given by [∫ ]

( ∫ s )

Vt (0) = E Q

exp − (ru − ỹu )du dDs Ft .

2

(4.3)

]t,T ] t

Then the original pre-default value is approximated as

8

4.1 Asymmetric Collateralization

We now consider two special cases under perfect collateralization δ 1 = δ 2 = 1 using the

previous result.

Case 1: The situation where the party 2 can only use the single collateral currency (j) but

party 1 chooses the optimal currency from the eligible set denoted by C. The evaluation

currency is (i). In this case, the Gateaux derivative is given by

[∫ T ( ∫ s ) ]

( ) Q(i)

( (i) )

(j,k)

∇Vt 0; max y (j,k)

=E exp − cu + yu(i,j)

du max(−Vs (0), 0) max ys Ft ,

k∈C t t k∈C

(4.5)

where [∫ ( ∫ s ) ]

( (i) )

Q(i)

Vt (0) = E exp − (i,j)

cu + yu du dDs Ft , (4.6)

]t,T ] t

which is straightforward to calculate. This case is particularly interesting since the situa-

tion can naturally arise if the sophistication of collateral management of one of the parties

is not enough to carry out optimal strategy, even when the relevant CSA is actually sym-

metric. We will carry out numerical study for this example in Sec. 7.

Case 2: The case of unilateral collateralization, where the party 2 is default-free and

do not post collateral. The party 1 needs to post collateral in currency (j) to fully

cover the exposure, or δ 1 = 1. The evaluation currency is (i). We expand the pre-

default value around the symmetric collateralization with currency (j). In this case,

(i) (j) (i) (i,j) (j)

R(t, Vt ) = rt − yt 1{Vt <0} = ct + yt + yt 1{Vt ≥0} .

[∫ ( ∫ s ) ]

( ) T ( (i) ) ( ) (j)

Q(i)

du max Vs (0), 0 ys ds Ft ,

(j)

∇Vt 0; yt 1{Vt ≥0} = −E exp − (i,j)

cu + yu

t t

(4.7)

where [∫ ( ∫ s ) ]

( (i) )

(i)

Vt (0) = E Q exp − cu + yu(i,j) du dDs Ft (4.8)

]t,T ] t

is the value in symmetric limit. Detailed implications for the one-way CSA will be dis-

cussed in a later section after considering remaining credit risk.

In both cases, the correction term seems a weighted average of European option on the

underlying contract. If we have analytic formula for Vt (0), it is straightforward to carry

out numerical calculation. The important factors determining the correction term are the

dynamics of y and V itself, and their interdependence. This point will be studied in later

sections.

As another important application of Gateaux derivative, we can consider CVA as a devi-

ation from the perfect collateralization. Most of the existing literature is neglecting the

9

cost of collateral for the calculation of CVA, which seems inappropriate considering the

signiﬁcant size and volatility of y, pointed out in our work [10] 2 .

Let us suppose yt1 = yt2 = yt for simplicity. In this case, we have

( )

µ(t, Vt ) = yt − (1 − δt1 )yt + (1 − Rt1 )(1 − δt1 )+ h1t − (1 − Rt2 )(δt1 − 1)+ h2t 1{Vt <0}

( )

− (1 − δt2 )yt + (1 − Rt2 )(1 − δt2 )+ h2t − (1 − Rt1 )(δt2 − 1)+ h1t 1{Vt ≥0} (5.1)

and consider the Gateaux derivative around the point of δ 1 = δ 2 = 1. The result can be

interpreted as a bilateral CVA that takes into account the cost of collateral and its coverage

ratio explicitly. There also appears a new term ”CCA” (collateral cost adjustment) that is

purely the adjustment of collateral cost totally independent from the counterparty credit

risk.

Following the method given in Ref. [5], one obtains

[∫

∫s

∇Vt = E Q e− t (ru −yu )du

(−Vs (0))×

]t,T ]

[{ }

(1 − δs1 )ys + (1 − Rs1 )(1 − δs1 )+ h1s − (1 − Rs2 )(δs1 − 1)+ h2s 1{Vs (0)<0}

{ } ] ]

+ (1 − δs2 )ys + (1 − Rs2 )(1 − δs2 )+ h2s − (1 − Rs1 )(δs2 − 1)+ h1s 1{Vs (0)≥0} Ft , (5.2)

where [∫ ( ∫ s ) ]

Vt (0) = E Q exp − (ru − yu )du dDs Ft , (5.3)

]t,T ] t

which represents the contract value under the perfect collateralization. Using the above

result, the contract value can be decomposed into three parts, one is the value under the

perfect collateralization, CCA (collateral cost adjustment) and CVA 3 .

This decomposition would be useful for practitioners who know that most of their exposure

is collateralized, but still care about the remaining small counter party exposure and

adjustment of collateral cost due to the deviation from the perfect collateralization 4 . It

is natural to expand around the perfectly collateralized limit, since it would be the only

choice that can achieve the required transparency as the benchmark price in the market.

By expanding Eq.(5.2), we have

[∫ T [ ]

∫ [ ]+ [ ]+ ]

CCA = E Q

e− ts (ru −yu )du

ys (1 − δs ) −Vs (0) − (1 − δs ) Vs (0)

1 2

ds Ft

t

(5.5)

2

For general treatment of CVA and related references, see Ref. [1], for example.

3

Our convention of CVA is diﬀerent from other literatures by sign where it is deﬁned as the ”charge”

to the clients. Thus, CVAours = −CVA.

4

One can perform the same procedures even if there exist asymmetry in collateralization. Since we

expand around symmetric limit, there also appears correction terms for asymmetry.

10

which is a pure adjustment of collateral cost due to the deviation from the perfect collat-

eralization, and independent from the credit risk.

For credit sensitive part, we have

CVA[ = ]

∫

−

∫s

(ru −yu )du

{ [ ]+ [ ]+ }

E Q

e t (1 − Rs1 )h1s (1 − δs1 )+−Vs (0) + (δs − 1) Vs (0)

2 +

ds Ft

]t,T ]

[∫ ]

∫s { [ [ ] }

e− t (ru −yu )du (1 − Rs2 )h2s (1 − δs2 )+ Vs (0)]+ + (δs1 − 1)+ −Vs (0)

+

−E Q ds Ft .

]t,T ]

(5.6)

Note that we have assumed ∆Vτ = 0 to derive Proposition 1. For those trades which

exhibit price jump at the time of default, such as CDS, we need to handle it separately.

The eﬀects of stochastic coverage ratio as well as non-zero jump at the time of default are

our ongoing research topics.

Although we leave detailed numerical study of CVA under collateralization for a separate

paper, let us make several qualitative observations here. Firstly, although the terms in

CVA are pretty similar to the usual result of bilateral CVA, the discounting rate is now

diﬀerent from the risk-free rate and reﬂects the funding cost of collateral. If there is no

dependency between y and other variables, such as hazard rate, the eﬀects of collateral-

ization would mainly appear through the modiﬁcation of discounting factor. As we have

studied in Ref. [10], the change of eﬀective discounting factor due to the choice of collateral

currency or optimal collateral strategy can be as big as several tens of percentage points.

This itself can modify the resultant CVA meaningfully. In the case of correlated y and

other variables, particularly the hazard rates, there may appear new type of ”wrong way”

risk. As we will see later, y is closely related to the CCS basis spread that reﬂects the

relative funding cost diﬀerence between the two currencies involved. Hence, y is expected

to be highly sensitive to the market liquidity, and hence is also strongly aﬀected by the

overall market credit conditions. Therefore, although the eﬃcient collateral management

signiﬁcantly reduce the credit risk, one needs to carefully estimate the remaining credit

exposures when there exists a meaningful deviation from the perfect collateralization.

Secondly, we can also expect important eﬀects from the stochastic coverage ratios.

If the main reason for the imperfectness of collateralization comes from price disputes

over exotic products, δ i may be well regressed by market skewness, volatility level, Libor-

OIS and CCS basis spreads, etc. This may create non-trivial dependence among the

collateral coverage ratio, the credit exposure, and also on the funding cost of collateral. By

monitoring the price disagreements, ﬁnancial ﬁrms should be able to construct a realistic

model of δ i for each counter party. It will be also useful for stress testing allowing higher

dependence among them.

Thirdly, as we have seen, there appears a new term called ”CCA” which adjusts the cost

of collateral from the perfect collateralization case. Dependent on the details of contracts

and correlation among the underlying variables, CCA can be as important as CVA. As can

be seen from Eq. (5.5), it will be particularly the case when there is signiﬁcant correlation

11

between the collateral cost y and the underlying contract value. A typical examples of the

products highly correlated with y are cross currency basis swap and probably sovereign

risk sensitive products.

As the last remark, the valuation of CVA is critically depend on the recovery or closeout

scheme in general, and the result may sometimes be counterintuitive and/or inappropriate,

as clearly demonstrated by the recent work of Brigo & Morini (2010) [2]. However, in the

case of a collateralized contract, the dependency on the closeout conventions is expected

to be quite small. This is because, the creditworthiness of both parties which enter the

substitution trade is largely ﬂattened by collateralization.

Let us consider several important examples:

Case 1: Consider the situation where the both parties use collateral currency (i), which

is the same as the payment currency. We also assume a common constant coverage ratio

δ 1 = δ 2 = δ (< 1), and also constant recovery rates. In this case, CCA and CVA are given

by

[∫ T ]

∫ (i)

CCA = −(1 − δ)E Q(i)

e ys Vs (0)ds Ft

− ts cu du (i)

(5.7)

t

[∫ T ]

∫ (i) ( )

CVA = (1 − R )(1 − δ)E

1 Q(i)

e − ts ci du 1

hs max −Vs (0), 0 ds Ft

t

[∫ T ]

∫ s (i) ( )

e− t cu du h2s max Vs (0), 0 ds Ft , (5.8)

(i)

−(1 − R2 )(1 − δ)E Q

t

where [∫ ( ∫ ) ]

s

Q(i)

Vt (0) = E exp − c(i)

u du dDs Ft (5.9)

]t,T ] t

is a value under perfect collateralization by domestic currency.

Case 2: Consider the situation where the both parties optimally choose collateral currency

(k) from the eligible collateral set C. The payments are done by currency (i). We assume

the common constant coverage ration δ (< 1) and constant recovery rates. In this case,

CCA and CVA are given by

[∫ T ]

∫

ys Vs (0)ds Ft

(i) (i,k)

Q(i) − ts (cu +maxk∈C yu )du (k)

CCA = −(1 − δ)E e (5.10)

t

[∫ T ]

∫ s (i) ( )

e− t (cu +maxk∈C yu )du h1s max −Vs (0), 0 ds Ft

(i) (i,k)

CVA = +(1 − R1 )(1 − δ)E Q

t

[∫ T ]

∫ ( )

hs max Vs (0), 0 ds Ft ,

(i) (i,k)

(i) − ts (cu +maxk∈C yu )du 2

−(1 − R )(1 − δ)E

2 Q

e

t

(5.11)

where [∫ ( ∫ s ) ]

( (i) )

Q(i)

Vt (0) = E exp − (i,k)

cu + max yu dDs Ft . (5.12)

]t,T ] t k∈C

12

An interesting point is that the optimal choice of collateral currency may signiﬁcantly

change the size of CVA relative to the single currency case due to the increase of eﬀective

discounting rates as discovered in Ref. [10].

Case 3: Let us consider another important situation, which is the unilateral collateraliza-

tion with bilateral default risk. Suppose the situation where only the party 2 is required to

post collateral due to its high credit risk relative to the party 1. We have δ 1 = 0, δ 2 ≃ 1,

and write yt2 = yt . In this case we have

[ ]

µ(t, Vt ) = yt − yt 1{Vt <0} + (1 − δt2 )yt 1{Vt ≥0}

( )

−(1 − Rt1 )h1t 1{Vt <0} − (δt2 − 1)+ 1{Vt ≥0} − (1 − Rt2 )(1 − δt2 )+ h2t 1{Vt ≥0} . (5.13)

[∫ T ∫s ( )

∇Vt = E Q e− t (ru −yu )du −Vs (0) ×

t

[ ( )

ys 1{Vs <0} + (1 − δs2 )ys 1{Vs ≥0} + (1 − Rs1 )h1s 1{Vs <0} − (δs2 − 1)+ 1{Vs ≥0}

] ]

+ (1 − Rs2 )(1 − δs2 )+ h2s 1{Vs ≥0} Ft . (5.14)

More speciﬁcally, if we assume the same collateral and payment currency (i), we have

where

[∫ ( ∫ ) ]

s

Q(i)

Vt (0) = E exp − c(i)

u du dDs Ft (5.16)

]t,T ] t

and

[∫ {[ ]

T ∫s ]+ [ ]+ }

ds Ft

(i)

Q(i) −

CCA = E e t cu du (i)

ys −Vs (0) − (1 − δs ) Vs (0)

2

t

(5.17)

[∫ {[ } ]

T ∫ s (i) ]+ [ ]+

e− t cu du (1 − Rs1 )hs −Vs (0) + (δs2 − 1)+ Vs (0) ds Ft

(i)

CVA = E Q 1

t

[∫ T ]

∫ (i) [ ]+

− ts cu du

(1 − Rs )(1 − δs ) hs Vs (0) ds Ft

(i)

−E Q

e 2 2 + 2

(5.18)

t

If party 1 receives ”strong” currency (that is the currency with high value of y (i) ), such

as USD (See, Ref. [10]), and also imposes stringent collateral management δ 2 ≃ 1 on the

counter party, it can enjoy signiﬁcant funding beneﬁt from CCA. The CVA terms are usual

bilateral credit risk adjustment except that the discounting is now given by the collateral

rate.

Note that, this example is particularly common when SSA (sovereign, supranational

and agency) is involved (as party 1). For example, when the party 1 is a central bank, it

13

does not post collateral but receives it. From the view point of the counterpart ﬁnancial

ﬁrm (party 2), this is a real headache. As we have explained in the introduction, since

party 2 has to enter bilateral collateralization when it tries to hedge the position in the

market, there clearly exists a signiﬁcant risk of cash-ﬂow mismatch. In addition, although

the contribution from the CVA will be negligible, there exists a big mark-to-market issue

from the CCA term. Even if it is not a critical matter at the current low-interest rate

market, once the market interest rate starts to go up while the overnight rate c is kept

low by the central bank to support economy, the resultant mark-to-market loss for the

party 2 can be quite signiﬁcant due to the rising cost of collateral ”y” (Remember that

y (i) = r(i) − c(i) ).

Case 4: Finally, let us consider the situation where there exist collateral thresholds. A

threshold is a level of exposure below which collateral will not be called, and hence it

represents an amount of uncollateralized exposure. If the exposure is above the threshold,

only the incremental exposure will be collateralized. Usually, the collateral thresholds are

set according to the credit standing of each counter party. They are often asymmetric,

with lower-rated counter party having a lower threshold than the higher-rated counter

party. It may be adjusted according to the ”triggers” linked to the credit rating during

the contract. We assume that the threshold of counter party i is set by Γit > 0, and that

the exceeding exposure is perfectly collateralized continuously.

In this case, Eq. (2.3) is modiﬁed in the following way:

[∫

St = βt E Q βu−1 1{τ >u} {dDu + q(u, Su )Su du}

]t,T ]

∫ ]

{ }

+ βu−1 1{τ ≥u} Z 1 (u, Su− )dHu1 + Z 2 (u, Su− )dHu2 Ft , (5.19)

]t,T ]

where

( ) ( )

Γ1 Γ2

q(t, St ) = yt1 1+ t 1{St <−Γ1t } + yt2 1− t 1{St ≥Γ2t } , (5.20)

St St

and

[( ) ]

Γ1

1

Z (t, St ) = St 1 + (1 − Rt1 ) t 1{St <−Γ1t } + Rt1 1{−Γ1t ≤St <0} + 1{St ≥0}

St

[( 2

) ]

2 Γt

2

Z (t, St ) = St 1 − (1 − Rt ) 2

1{St ≥Γ2t } + Rt 1{0≤St <Γ2t } + 1{St <0} .

St

Here, we have assumed the same recovery rate for the uncollateralized exposure regardless

of whether the contract value is above or below the threshold.

Following the same procedures given in Appendix A, one can show that the pre-default

value of the contract Vt is given by

[∫ ( ∫ s ) ]

( )

Vt = E Q

exp − ru − µ(u, Vu ) du dDs Ft , t ≤ T (5.21)

]t,T ] t

14

where

[ ]

( 1 ) Γ1t

− yt + ht (1 − Rt ) 1{−Γ1t ≤Vt <0} − 1{Vt <−Γ1t }

1 1

Vt

[ ]

( 2 ) Γ 2

− yt + h2t (1 − Rt2 ) 1{0≤Vt <Γ2t } + t 1{Vt ≥Γ2t } . (5.22)

Vt

Now, consider the case where the both parties use the same collateral currency (i),

which is equal to the evaluation currency of the contract. Then, we have

{

(i) (i)

µ(t, Vt ) = yt − yt 1{−Γ1t ≤Vt <Γ2t }

[ 1 ]

(i) Γt Γ2t

+yt 1 1 − 1

Vt {Vt <−Γt } Vt {Vt ≥Γt }

2

[ ]

Γ1t

−ht (1 − Rt ) 1{−Γ1t ≤Vt <0} − 1{Vt <−Γ1t }

1 1

Vt

[ ]}

Γ2

−h2t (1 − Rt2 ) 1{0≤Vt <Γ2t } + t 1{Vt ≥Γ2t } . (5.23)

Vt

Hence, if we apply Gateaux derivative around the symmetric perfect collateralization with

(i)

currency (i) that is µ(t, Vt ) = yt , we obtain

where [∫ ( ∫ ) ]

s

Q(i)

Vt (0) = E exp − c(i) du dD s Ft , (5.25)

]t,T ] t

u

and

[∫ ]

T ∫s

ys Vs (0)1{−Γ1s ≤Vs (0)<Γ2s } ds Ft

(i)

Q(i) −

CCA = −E e t cu du (i)

t

[∫ ]

T ∫s [ 1 ]

Γs 1{Vs (0)<−Γ1s } − Γs 1{Vs (0)≥Γ2s } ds Ft

(i)

Q(i) − cu du (i) 2

+E e t ys (5.26)

t

[∫ ∫ (i) [

]

T ( )]

CVA = −E Q(i)

e hs (1 − Rs ) Vs (0)1{−Γ1s ≤Vs (0)<0} − Γs 1{Vs (0)<−Γ1s } ds Ft

− ts cu du 1 1 1

t

[∫ ∫ (i) [

]

T ( )]

−E Q(i)

e hs (1 − Rs ) Vs (0)1{0<Vs (0)≤Γ2s } + Γs 1{Vs (0)>Γ2s } ds Ft .

− ts cu du 2 2 2

t

(5.27)

It is easy to see that the terms in CCA are reﬂecting the fact that no collateral is being

posted in the range {−Γ1t ≤ Vt ≤ Γ2t }, and that the posted amount of collateral is smaller

than |V | by the size of threshold. The terms in CVA represent bilateral uncollateralized

credit exposure, which is capped by each threshold.

15

6 Fundamental Instruments

In order to study the quantitative eﬀects of collateralization and its implications on CVA,

we need to understand the pricing of fundamental instruments under symmetric collateral-

ization. It is also necessary for the calibration of the model in the ﬁrst place. One obtains

detailed discussion in Refs [7, 8, 10], but we extend the results for stochastic y spread and

summarize in this section. We also introduce a slightly simpler cross currency swap, which

is actually tradable in the market, in order to show the direct link of CCS with the cost

of collateral in much simpler fashion. All the results easily follow from Sec. 3.

Throughout this section, we assume that the market quotes of standard products

are the values under symmetric and perfect collateralization, which should be reasonable

considering dominant role of major broker-dealers for these products and their stringent

collateral management. If it is not the case, value of any contract becomes dependent on

the portfolio to a speciﬁc counter party, which makes it impossible for ﬁnancial ﬁrms to

agree on the market prices. In fact, to achieve enough transparency in the market quotes,

the broker-dealers should specify the details of CSA to avoid contamination from contracts

with non-standard collateral agreements.

A collateralized zero coupon bond is the most fundamental asset for the valuation of all

the contracts with collateral agreements. We denote a zero coupon bond collateralized by

the domestic currency (i) as

[ ∫ T (i) ]

e− t cs ds Ft

(i)

D(i) (t, T ) = E Q (6.1)

If payment and collateralized currencies are diﬀerent, (i) and (j) respectively, a foreign

collateralized zero coupon bond D(i,j) is given by

[ ∫ T (i) ( ∫ T (i,j) ) ]

e− t cs ds e− t ys ds Ft .

(i)

D(i,j) (t, T ) = E Q (6.2)

∫T

D(i,j) (t, T ) = D(i) (t, T )e− t y (i,j) (t,s)ds

, (6.3)

where [ ∫ s (i,j) ]

1

e− t yu du Ft

(i)

y (i,j) (t, s) = − ln E Q (6.4)

s

denotes the forward y (i,j) spread.

Because of the existence of collateral, FX forward transaction now becomes non-trivial.

The precise understanding of the collateralized FX forward is crucial to deal with generic

collateralized products.

The deﬁnition of currency-(k) collateralized FX forward contract for the currency pair

16

(i, j) is as follows:

• At the time of trade inception t, both parties agree to exchange K unit of currency (i)

with the one unit of currency (j) at the maturity T . Throughout the contract period, the

continuous collateralization by currency (k) is performed, i.e. the party who has negative

mark-to-market value need to post the equivalent amount of cash in currency (k) to the

counter party as collateral, and this adjustment is made continuously. FX forward rate

(i,j)

fx (t, T ; k) is defined as the value of K that makes the value of contract at the inception

time zero.

Q(i) − cs +ys ds (j) − cs +ys ds

KE e Ft − fx(i,j) (t)E Q Ft = 0

t

e t

(6.5)

[ ∫ T ( (j) (j,k) ) ]

(j) − cs +ys ds

EQ e Ft

t

− tT cs +ys ds

Ft

(i)

EQ e

D(j,k) (t, T )

= fx(i,j) (t) , (6.7)

D(i,k) (t, T )

we have

[ ∫ ( ) ] [ ]

(i) (i,k)

− tT cs +ys

Q(i)

fx (T ) Ft = D(i,k) (t, T )E T

ds (i,j) (i,k)

E e fx(i,j) (T, T ; k) Ft

Here, we have deﬁned the (k)-collateralized (i) forward measure T (i,k) , where D(i,k) (·, T )

(i,k)

is used as the numeraire. E T [·] denotes expectation under this measure.

The overnight index swap (OIS) is a ﬁxed-vs-ﬂoating swap which is the same as the usual

IRS except that the ﬂoating leg pays periodically, say quarterly, daily compounded ON

rate instead of Libors. Let us consider T0 -start TN -maturing OIS of currency (j) with

ﬁxed rate SN , where T0 ≥ t. If the party 1 takes a receiver position, we have

[ (∫ )]

∑N Tn

dDs = δTn (s) ∆n SN + 1 − exp c(j)

u du (6.9)

n=1 Tn−1

where ∆ is day-count fraction of the ﬁxed leg, and δT (·) denotes Dirac delta function at

T.

17

Using the results of Sec. 3, in the case of currency (k) collateralization, we have

[∫ ( ∫ s ) ]

( )

(j) (j)

Vt = EQ exp − c(j) + y (j,k)

du dD s Ft (6.10)

]T0 ,TN ] t

u u

∑ [ ∫ ( ) ( ∫ Tn ) ]

cu du

N (j)

Tn (j) (j,k)

= EQ

(j)

e− t cu +yu du

∆n SN + 1 − e Tn−1 Ft . (6.11)

n=1

∑

N ( )

(j)

Vt = ∆n D(j) (t, Tn )SN − D(j) (t, T0 ) − D(j) (t, TN ) , (6.12)

n=1

SN = ∑N (j)

. (6.13)

n=1 ∆n D (t, Tn )

Cross currency swap (CCS) is one of the most fundamental products in FX market. Espe-

cially, for maturities longer than a few years, CCS is much more liquid than FX forward

contract, which gives CCS a special role for model calibrations. The current market is

dominated by USD crosses where 3m USD Libor ﬂat is exchanged by 3m Libor of a dif-

ferent currency with additional (negative in many cases) basis spread. The most popular

type of CCS is called MtMCCS (Mark-to-Market CCS) in which the notional of USD leg

is rest at the start of every calculation period of Libor, while the notional of the other leg

is kept constant throughout the contract period. For model calibration, MtMCCS should

be used as we have done in Ref. [10] considering its liquidity. However, in this paper, we

study a diﬀerent type of CCS, which is actually tradable in the market, to make the link

between y and CCS much clearer.

We study the Mark-to-Market cross currency overnight index swap (MtMCCOIS),

which is exactly the same as the usual MtMCCS except that it pays a compounded ON

rate, instead of the Libor, of each currency periodically. Let us consider (i, j)-MtMCCOIS

where currency (i) intended to be USD and needs notional refreshments, and currency (j)

is the one in which the basis spread is to be paid. Let us suppose the party 1 is the spread

receiver and consider T0 -start TN -maturing (i, j)-MtMCCOIS. For the (j)-leg, we have

∑

N [( ∫ Tn (j)

) ]

cu du

dDs(j) = −δT0 (s) + δTN (s) + δTn (s) e Tn−1

− 1 + δ n BN , (6.14)

n=1

where BN is the basis spread of the contract. For (i)-leg, in terms of currency (i), we have

N [

∑ ∫ Tn (i)

]

cu du

dDs(i) = δTn−1 (s)fx(i,j) (Tn−1 ) − δTn (s)fx(i,j) (Tn−1 )e Tn−1 . (6.15)

n=1

18

In total, in terms of currency (j), we have

[ ]

∑N

fx

(j,i)

(T n )

∫ Tn

c

(i)

du

= dDs(j) + δTn−1 (s) − δTn (s) (j,i)

u

e Tn−1 (6.17)

n=1 fx (Tn−1 )

[ ]

∑N ∫ Tn

c

(j)

du f

(j,i)

x (Tn )

∫ Tn

c

(i)

du

+ δn BN − (j,i)

u u

= δTn (s) e Tn−1 e Tn−1 . (6.18)

n=1 f x (T n−1 )

If the collateralization is done by currency (k), then the value for the party 1 is given

by

[ { } ]

∑

N ∫ Tn ∫ Tn (j,i) ∫ Tn

(j) (j,k) (j)

cu du fx (Tn ) (i)

cu du

Vt = E Q(j)

e− t (cu +yu )du

e Tn−1 + δn BN − (j,i) e Tn−1 Ft ,

fx (Tn−1 )

n=1

(6.19)

where T0 ≥ t. In particular, let us consider the case where the swap is collateralized by

currency (i) (or USD), which looks popular in the market.

∑

N ∫ Tn

Vt = δn BN D(j) (t, Tn )e− t y (j,i) (t,u)du

n=1

∑

N ∫ Tn−1

( ∫ Tn )

− y (j,i) (t,u)du − y (j,i) (t,u)du

− D (j)

(t, Tn−1 )e t 1−e Tn−1

n=1

N [

∑ ( ∫ Tn )]

− y (j,i) (t,u)du

= δ n BN D (j,i)

(t, Tn ) − D (j,i)

(t, Tn−1 ) 1 − e Tn−1

. (6.20)

n=1

Here, we have assumed the independence of c(j) and y (j,i) . In fact, the assumption seems

reasonable according to the recent historical data studied in Ref. [10]. In this case, we

obtain the par MtMCCOIS basis spread as

( ∫ )

∑N − TTn y (j,i) (t,u)du

n=1 D

(j,i) (t, Tn−1 ) 1 − e n−1

BN = ∑N (j,i) (t, T )

. (6.21)

n=1 δn D n

∫ TN

1

BN ∼ y (j,i) (t, u)du, (6.22)

TN − T0 T0

which gives us the relation between the relative diﬀerence of collateral cost y (j,i) and the

observed cross currency basis. Therefore, the cost of collateral y is directly linked to the

dynamics of CCS markets.

Here, let us comment about the origin of y spread in our pricing formula in Proposition 1.

Consider the following hypothetical but plausible situation to get a clear image:

19

(1): An interest rate swap market where the participants are discounting future cash flows

by domestic OIS rate, regardless of the collateral currency, and assume there is no price

dispute among them. (2): Party 1 enters two opposite trades with party 2 and 3, and they

are agree to have CSA which forces party 2 and 3 to always post a domestic currency U

as collateral, but party 1 is allowed to use a foreign currency E as well as U . (3): There

is very liquid CCOIS market which allows firms to enter arbitrary length of swap. The

spread y is negative for CCOIS between U and E, where U is a base currency (such as

USD in the above explanation).

In this example, the party 1 can deﬁnitely make money. Suppose, at a certain point, the

party 1 receives N unit amount of U from the party 2 as collateral. Party 1 enters a

CCOIS as spread payer, exchanging N unit amount of U and the corresponding amount

of E, by which it can ﬁnance the foreign currency E by the rate of (E’s OIS +y). Party

1 also receives U ’s OIS rate from the CCOIS counter party, which is going to be paid

as the collateral margin to the party 2. Party 1 also posts E to the party 3 since it has

opposite position, it receives E’s OIS rate as the collateral margin from the party 3. As

a result, the party 1 earns −y (> 0) on the notional amount of collateral. It can rollover

the CCOIS, or unwind it if y’s sign ﬂips.

Of course, in the real world, CCS can only be traded with certain terms which makes

the issue not so simple. However, considering signiﬁcant size of CCS spread (a several tens

of bps) it still seems possible to arrange appropriate CCS contracts to achieve cheaper

funding. For a very short term, it may be easier to use FX forward contracts for the same

purpose. In order to prohibit this type of arbitrage, party 1 should pay extra premium

to make advantageous CSA contracts. This is exactly the reason why our pricing formula

contains the spread y.

For the details of calibration procedures, the numerical results and recent historical behav-

ior of underlyings are available in Refs. [7, 10]. The procedures can be brieﬂy summarized

as follows: (1) Calibrate the forward collateral rate c(i) (0, t) for each currency using OIS

market. (2) Calibrate the forward Libor curves by using the result of (1), IRS and tenor

swap markets. (3) Calibrate the forward y (i,j) (0, t) spread for each relevant currency pair

by using the results of (1),(2) and CCS markets.

Although we can directly obtains the set of y (i,j) from CCS, we cannot uniquely deter-

mine each y (i) , which is necessary for the evaluation of Gateaux derivative when we deal

with unilateral collateralization and CCA (collateral cost adjustment). For these cases,

we need to make an assumption on the risk-free rate for one and only one currency. For

example, if we assume that ON rate and the risk-free rate of currency (j) are the same,

and hence y (j) = 0, then the forward curve of y USD is ﬁxed by y USD (0, t) = −y (j,USD) (0, t).

Then using the result of y USD , we obtains {y (k) } for all the other currencies by making

use of {y (k,USD) } obtained from CCS markets. More ideally, each ﬁnancial ﬁrm may carry

out some analysis on the risk-free proﬁt rate of cash pool or more advanced econometric

analysis on the risk-free rate, such as those given in Feldhütter & Lando (2008) [6].

20

7 Numerical Studies for Asymmetric Collateralization

In this section, we study the eﬀects of asymmetric collateralization on the two fundamental

products, MtMCCOIS and OIS, using Gateaux derivative. For both cases, we use the

following dynamics in Monte Carlo simulation:

( )

(j) (j)

dct = θ(j) (t) − κ(j) ct dt + σc(j) dWt1 (7.1)

( )

(i) (i)

dct = θ(i) (t) − ρ2,4 σc(i) σx(j,i) − κ(i) ct dt + σc(i) dWt2 (7.2)

( )

(j,i) (j,i)

dyt = θ(j,i) (t) − κ(j,i) yt dt + σy(j,i) dWt3 (7.3)

( )

(j,i) (j) (i) (j,i) 1

d ln fx t = ct − ct + yt − (σx(j,i) )2 dt + σx(j,i) dWt4 (7.4)

2

where {W i , i = 1 · · · 4} are Brownian motions under the spot martingale measure of cur-

rency (j). Every θ(t) is a deterministic function of time, and is adjusted in such a way that

we can recover the initial term structures of the relevant variable. We assume every κ and

σ are constants. We allow general correlation structure (d[W i , W j ]t = ρi,j dt) except that

ρ3,j = 0 for all j ̸= 3. The above dynamics is chosen just for simplicity and demonstrative

purpose, and generic HJM framework can also be applied to the evaluation of Gateaux

derivative. For details of more general dynamics in HJM framework, see Refs. [8, 9]. In

the following, we use the term structure for the (i, j) pair taken from the typical data of

(USD, JPY) in early 2010 for presentation. In Appendix E, we have provided the term

structures and other parameters used in calculation.

The discussed form of asymmetry is particularly interesting, since even if the relevant

CSA is actually symmetric, the asymmetry arises eﬀectively if there is diﬀerence in the

level of sophistication of collateral management. From the following two examples, one

can see that the eﬃcient collateral management is practically relevant and the ﬁrms who

are incapable of doing so will have to pay quite expensive cost to the counter party, and

vice versa.

We now implement Gateaux derivative using Monte Carlo simulation based on the model

we have just explained. To see the reliability of Gateaux derivative, we have compared it

with a numerical result directly obtained from PDE using a simpliﬁed setup in Appendix D.

Firstly, we consider MtMCCOIS explained in Sec. 6.4. We consider a spot-start, TN -

maturing (i, j)-MtMCCOIS, where the leg of currency (i) (intended to be USD) needs

notional refreshments. Let us assume perfect but asymmetric collateralization as follows:

(1) Party 1 is the basis spread payer and can use either the currency (i) or (j) as collateral.

(2) Party 2 is the basis spread receiver and can only use the currency (i) as collateral.

In this case, the price of the contract at time 0 from the view point of party 1 is given

by [∫ ]

( ∫ s )

Q(j)

V0 = E exp − R(u, Vu )du dDs (7.5)

]0,TN ] 0

21

where ( (j,i) )

(j) (j,i)

R(t, Vt ) = ct + yt + max −yt , 0 1{Vt <0} , (7.6)

and

{ [ ]}

∑

N ∫ Tn (j)

cu du fx

(j,i)

(Tn )

∫ Tn (i)

cu du

dDs = δTn (s) −e Tn−1

− δn B + (j,i)

e Tn−1

. (7.7)

n=1 fx (Tn−1 )

( )

V0 ≃ V0 (0) + ∇V0 0; max(−y (j,i) , 0) , (7.8)

where

( )

∇V0 0; max(−y (j,i) , 0)

[∫ TN ]

Q(j)

∫ (j) (j,i)

− 0s (cu +yu )du

( ) ( (j,i) )

=E e max −Vs (0), 0 max −ys , 0 ds . (7.9)

0

Although Vt (0) is simply a price under symmetric collateralization using currency (i), we

need to be careful about the advance reset conventions. One can show that

[ { } ]

∑N ∫ ∫ Tn (j,i) ∫ Tn

Q(j)

(j) (j,i)

− tTn (cu +yu )du c

(j)

du f x (T n ) c

(i)

du

−e − δn B + (j,i) Ft

Tn−1 u Tn−1 u

Vt (0) = E e e

fx (Tn−1 )

n=γ(t)+1

( ) ∫t

(i)

∫ Tγ(t) (j) ∫t ∫ Tγ(t) (j)

e Tγ(t)−1 cu du ∫ T

Tγ(t)−1 + t cu du

fx (Tγ(t) ) Ft ,

(j,i) γ(t) (i)

Q(j) − t

+E e (cu +yu )du

−e − δγ(t) B + (j,i) e t cu du (j,i)

fx (T )

γ(t)−1

(7.10)

where γ(t) = min{n; Tn > t, n = 1 · · · N }. Note that Tγ(t)−1 < t since we are considering

spot-start swap (or T0 = 0). Assuming the independence of y (j,i) and other variables, we

can simplify Vt (0) and obtains

∑

N ∑

N ( )

Vt (0) = − D (j)

(t, Tn )Y (j,i)

(t, Tn )δn B + D(j) (t, Tn−1 ) Y (j,i) (t, Tn−1 ) − Y (j,i) (t, Tn )

n=γ(t) n=γ(t)+1

∫t (j) (j,i) ∫t (i)

cs ds fx (t) Tγ(t)−1 cs ds

−Y (j,i) (t, Tγ(t) )e Tγ(t)−1

+ (j,i)

e , (7.11)

fx (Tγ(t)−1 )

[ ∫ T (j,i) ]

e− t ys ds Ft .

(j)

where we have deﬁned Y (j,i) (t, T ) = E Q

In Figs. 1 and 2, we have shown the numerical result of Gateaux derivative, which is

the price diﬀerence from the symmetric limit, for 10y and 20y MtMCCOIS, respectively.

The spread B was chosen in such way that the value in symmetric limit, V0 (0), becomes

zero. In both cases, the horizontal axis is the annualized volatility of y (j,i) , and the vertical

one is the price diﬀerence in terms of bps of notional of currency (j). When the party 1

is the spread receiver, we have used the right axis. The results are rather insensitive to

the FX volatility due to the notional refreshments of currency-(i) leg. From the historical

22

analysis performed in Ref. [10], we know that annualized volatility of y (j,i) tends to be

50bps or so in a calm market, but it can be (100 ∼ 200)bps or more in a volatile market

for major currency pairs, such as (EUR,USD) and (USD, JPY). Therefore, the impact of

asymmetric collateralization in this example can be practically very signiﬁcant when party

1 is the spread payer. When the party 1 is the spread receiver, one sees that the impact of

asymmetry is very small, only a few bps of notional. This can be easily understood in the

following way: When the party 1 has a negative mark-to-market value and has the option

to change the collateral currency, y (j,i) tends to be large and hence the optimal currency

remains the same currency (i).

Finally, let us brieﬂy mention about the standard MtMCCS with Libor payments. As

discussed in Ref. [10], the contribution from Libor-OIS spread to CCS is not signiﬁcant rel-

ative to that of y (j,i) . Therefore, the numerical signiﬁcance of asymmetric collateralization

is expected to be quite similar in the standard case, too.

Now we study the impact of asymmetric collateralization on OIS. We consider OIS of

currency (j), and assume the following asymmetry in collateralization:

(1) Party 1 is the ﬁxed receiver and can use either the currency (i) or (j) as collateral.

(2) Party 2 is the ﬁxed payer can only use the currency (j) (domestic currency) as collateral.

[∫ ]

∫s

Q(j) − R(u,Vu )du

V0 = E e 0 dDs , (7.12)

]0,TN ]

where

∑

N [ ( ∫T (j)

)]

n cu du

dDs = δTn (s) δn S − e Tn−1 −1 , (7.13)

n=1

and

(j) (j,i)

R(t, Vt ) = ct + max(yt , 0)1{Vt <0} . (7.14)

Using Gateaux derivative, the above swap value can be approximated as

( ( (j,i) ))

V0 ≃ V0 (0) + ∇Vt 0; max yt , 0 , (7.15)

where

( [∫ ]

( (j,i) )) Q(j)

T

−

∫s (j) ( ) ( (j,i) )

∇V0 0; max y , 0 = E e 0 cu du

max −Vs (0), 0 max ys , 0 ds , (7.16)

0

and

∑ { ( ∫T )}

N ∫ Tn n (j)

− 1 Ft

(j)

Vt (0) = E Q

(j)

e− t cu du

δn S − e Tn−1

cu du

n=γ(t)

∫t

∑

N (j)

cu du

= D (j)

(t, Tn )δn S − e Tγ(t)−1

+ D(j) (t, TN ) . (7.17)

n=γ(t)

23

Here, S is the ﬁxed OIS rate.

In Figs. 3, 4, and 5, we have shown the numerical results Gateaux derivative for 10y

(j) (j,i)

and 20y OIS. In the ﬁrst two ﬁgures, we have ﬁxed σc = 1% and changed σy to

see the sensitivity against CCS. In the last ﬁgure, we have ﬁxed the y (j,i) volatility as

(j,i)

σy = 0.75% and changed the volatility of collateral rate c(j) . Since the term structure

of OIS rate is upward sloping, the mark-to-market value of a receiver tends to be negative

in the long end of the contract, which makes the optionality of collateral currency choice

larger and hence bigger price diﬀerence relative to the payer case.

From the results of section 7, we have seen the practical signiﬁcance of asymmetric collat-

eralization. It is now clear that sophisticated ﬁnancial ﬁrms may obtain signiﬁcant funding

beneﬁt from the less-sophisticated counter parties by carrying out clever collateral strate-

gies.

Before concluding the paper, let us explain two generic implications of collateralization

one for netting and the other for resolution of information, which is closely related to the

observation just explained. Although derivation itself can be done in exactly the same

way as Ref. [3] after the reinterpretation of several variables, we get new insights for

collateralization that can be important for the appropriate design and regulations for the

ﬁnancial market.

Proposition 2 5 Assume perfect collateralization. Suppose that, for each party i, yti

is bounded and does not depend on the contract value directly. Let V a , V b , and V ab

be, respectively, the value processes (from the view point of party 1) of contracts with

cumulative dividend processes Da , Db , and Da + Db . If y 1 ≥ y 2 , then V ab ≥ V a + V b ,

and if y 1 ≤ y 2 , then V ab ≤ V a + V b .

The party who has the higher funding cost y due to asymmetric CSA or lack of sophistica-

tion in collateral management prefer to have netting agreements to decrease funding cost.

On the other hand, an advanced ﬁnancial ﬁrm who has capability to carry out optimal

collateral strategy to achieve the lowest possible value of y tries to avoid netting to exploit

funding beneﬁt. For example, an advanced ﬁrm may prefer to enter an opposite trade

with a diﬀerent counterparty rather than to unwind the original trade. For standardized

products traded through CCPs, such a ﬁrm may prefer to use several clearing houses

cleverly to avoid netting.

The above ﬁnding seems slightly worrisome for the healthy development of CCPs. Ad-

vanced ﬁnancial ﬁrms that have sophisticated ﬁnancial technology and operational system

are usually primary members of CCPs, and some of them are trying to set up their own

clearing service facility. If those ﬁrms try to exploit funding beneﬁt, they avoid concentra-

tion of their contracts to major CCPs and may create very disperse interconnected trade

5

We assume perfect collateralization just for clearer interpretation. The results will not change quali-

tatively as long as δ i yti > (1 − Rti )(1 − δti )+ hit − (1 − Rtj )(δti − 1)+ hjt .

24

networks and may reduce overall netting opportunity in the market. Although remaining

credit exposure is very small as long as collateral is successfully being managed, the dis-

persed use of CCPs may worsen the systemic risk once it fails. In the work of Duﬃe &

Huang [3], the corresponding proposition is derived in the context of bilateral CVA. We

emphasize that one important practical diﬀerence is the strength of incentives provided

to ﬁnancial ﬁrms. Although it is somewhat obscure how to realize proﬁt/loss reﬂected in

CVA, it is rather straightforward in the case of collateralization by making use of CCS

market as we have explained in the remarks of Sec. 6.4.

We once again follow the setup given in Ref [3]. We assume the existence of two markets:

One is market F , which has ﬁltration F, that is the one we have been studying. The other

one is market G with ﬁltration G = {Gt : t ∈ [0, T ]}. The market G is identical to the

market F except that it has earlier resolution of uncertainty, or in other words, Ft ⊆ Gt

for all t ∈ [0, T ] while F0 = G0 . The spot marting measure Q is assumed to apply to the

both markets.

bounded and does not depend on the contract value directly. Suppose that r, y 1 and y 2 are

adapted to both the filtrations F and G. The contract has cumulative dividend process D,

which is a semimartingale of integrable variation with respect to filtrations F and G. Let

V F and V G denote, respectively, the values of the contract in markets F and G from the

view point of party 1. If y 1 ≥ y 2 , then V0F ≥ V0G , and if y 1 ≤ y 2 , then V0F ≤ V0G .

Proof is available in Appendix C. The proposition implies that the party who has the

higher eﬀective funding cost y either from the lack of sophisticated collateral management

technique or from asymmetric CSA would like to delay the information resolution to avoid

timely margin call from the counterparty. The opposite is true for advanced ﬁnancial ﬁrms

which are likely to have advantageous CSA and sophisticated system. The incentives

to obtain funding beneﬁt will urge these ﬁrms to provide mark-to-market information

of contracts to counter parties in timely manner, and seek early resolution of valuation

dispute to achieve signiﬁcant funding beneﬁt. Considering the privileged status of these

ﬁrms, the latter eﬀects will probably be dominant in the market.

9 Conclusions

This article develops the methodology to deal with asymmetric and imperfect collateral-

ization as well as remaining counterparty credit risk. It was shown that all of the issues

are able to be handled in an uniﬁed way by making use of Gateaux derivative. We have

shown that the resulting formula contains CCA that represents adjustment of collateral

cost due to the deviation from the perfect collateralization, and the terms corresponding

CVA, which now contains the possible dependency among cost of collaterals, hazard rates,

collateral coverage ratio and the underlying contract value. Even if we assume that the

6

We assume perfect collateralization just for clearer interpretation. The results will not change quali-

tatively as long as δ i yti > (1 − Rti )(1 − δti )+ hit − (1 − Rtj )(δti − 1)+ hjt .

25

collateral coverage ratio and recovery rate are constant, the change of eﬀective discount-

ing rate induced by collateral cost and its correlation to other variables may signiﬁcantly

change the value of CVA.

Direct link of CCS spread and collateral cost allows us to study the numerical signif-

icance of asymmetric collateralization. From the numerical analysis using CCS and OIS,

the relevance of sophisticated collateral management is now clear. If a ﬁnancial ﬁrm is

incapable of choosing the cheapest collateral currency, it has to pay very expensive funding

cost to the counter party. We also explained the issue of one-way CSA, which is common

when SSA entities are involved. If the funding cost of collateral (or ”y”) rises, the ﬁnancial

ﬁrm that is the counterparty of SSA may suﬀer from signiﬁcant loss of mark-to-market

value as well as the huge cash-ﬂow mismatch.

The article also discussed some generic implications of collateralization. In particular,

it was shown that the sophisticated ﬁnancial ﬁrms are likely to avoid netting of trades

if they try to exploit funding beneﬁt as much as possible, which may reduce the overall

netting opportunity and potentially increase the systemic risk in the ﬁnancial market.

A Proof of Proposition 1

Firstly, we consider the SDE for St . Let us deﬁne Lt = 1 − Ht . One can show that

∫ ∫

−1 −1

( ) ( )

βt St + βu Lu dDu + q(u, Su )Su du + βu−1 Lu− Z 1 (u, Su− )dHu1 + Z 2 (u, Su− )dHu2

]0,t] ]0,t]

[∫

{ ( ) }

= EQ βu−1 1{τ >u} dDu + yu1 δu1 1{Su <0} + yu2 δu2 1{Su ≥0} Su du

]0,T ]

∫ ]

( )

+ βu−1 Lu− Z 1 (u, Su− )dHu1 + Z 2 (u, Su− )dHu2 Ft = mt (A.1)

]0,T ]

where

q(t, v) = yt1 δt1 1{v<0} + yt2 δt2 1{v≥0} (A.2)

and {mt }t≥0 is a Q-martingale. Thus we obtain the following SDE:

( ) ( )

dSt − rt St dt + Lt dDt + q(t, St )St dt + Lt− Z 1 (t, St− )dHt1 + Z 2 (t, St− )dHt2 = βt dmt .

(A.3)

Using the decomposition of Hti , we get

( ) ( )

dSt − rt St dt + Lt dDt + q(t, St )St dt + Lt Z 1 (t, St )h1t + Z 2 (t, St )h2t dt = dnt , (A.4)

( )

dnt = βt dmt − Lt− Z 1 (t, St− )dMt1 + Z 2 (t, St− )dMt2 (A.5)

and {nt }t≥0 is also a some Q-martingale. Using the fact that

( )

q(t, St )St + Z 1 (t, St )h1t + Z 2 (t, St )h2t = St µ(t, St ) + ht , (A.6)

( )

dSt = −Lt dDt + Lt rt − µ(t, St ) − ht St dt + dnt . (A.7)

26

Secondly, let us consider the SDE for Vt . By following the similar procedures, one can

easily see that

∫ ( ) ∫ ∫ ( )

− 0t ru −µ(u,Vu ) du − 0s ru −µ(u,Vu ) du

e Vt + e dDs

]0,t]

[∫ ( ∫ s ) ]

( )

=E Q

exp − ru − µ(u, Vu ) du dDu Ft = m̃t , (A.8)

]0,T ] 0

( )

dVt = −dDt + rt − µ(t, Vt ) Vt dt + dñt , (A.9)

where ∫ t( )

ru −µ(u,Vu ) du

dñt = e 0 dm̃t , (A.10)

and hence {ñt }t≥0 is also a Q-martingale. As a result we have

= Lt− dVt − Vt− dHt − ∆Vτ ∆Hτ

( )

= −Lt− dDt + Lt rt − µ(t, Vt ) Vt dt − Lt Vt ht dt − ∆Vτ ∆Hτ

( )

+Lt− dñt − Vt− (dMt1 + dMt2 )

( )

= −Lt dDt + Lt rt − µ(t, Vt ) − ht Vt dt − ∆Vτ ∆Hτ + dÑt , (A.11)

( )

dÑt = Lt− dñt − Vt− (dMt1 + dMt2 ) . (A.12)

Therefore, by comparing Eqs. (A.7) and (A.11) and also the fact that ST = 1{τ >T } VT = 0,

we cannot distinguish 1{τ >t} Vt from St if there is no jump at the time of default ∆Vτ = 0.

B Proof of Proposition 2

Consider the case of y 1 ≥ y 2 . From Eq. (2.6), one can show that the pre-default value V

can also be written in the following recursive form:

[ ∫ ∫ ]

( )

Vt = E Q

− rs − µ(s, Vs ) Vs ds + dDs Ft . (B.1)

]t,T ] ]t,T ]

∫t

Ṽt = e− 0 (rs −ys )ds

1

Vt (B.2)

∫ ∫s

e− (ru −yu

1 )du

D̃t = 0 dDs . (B.3)

]0,t]

Note that

= (rt − yt1 ) + ηt1,2 1{Vt ≥0} , (B.4)

27

where we have deﬁned η i,j = y i − y j . Using new variables, Eq. (B.1) can be rewritten as

[ ∫ ∫ ]

Ṽt = E Q

− 1,2

ηs 1{Ṽs ≥0} Ṽs ds + dD̃s Ft . (B.5)

]t,T ] ]t,T ]

[ ∫ ]

( ( ) ( ) ( ) )

Ṽtab − Ṽta − Ṽtb = E Q − ηs1,2 max Ṽsab , 0 − max Ṽsa , 0 − max Ṽsb , 0 ds Ft .

]t,T ]

(B.6)

Let us denote the upper bound of η 1,2 as α, and also deﬁne Y = Ṽ ab − Ṽ a − Ṽ b and

( ( ) ( ) ( ))

Gs = −ηs1,2 max Ṽsab , 0 − max Ṽsa , 0 − max Ṽsb , 0 . Then, we have YT = 0 and

[∫ ]

Y = EQ Gs ds Ft . (B.7)

]t,T ]

(

( ab ) ( a ) ( b ))

Gs = −ηs1,2

max Ṽs , 0 − max Ṽs , 0 − max Ṽs , 0

( )

≥ −ηs1,2 max(Ṽsab , 0) − max(Ṽsa + Ṽsb , 0)

( )

≥ −ηs1,2 max Ṽsab − Ṽsa − Ṽsb , 0

≥ −α|Ys | . (B.8)

Ref. [4] to Y and G, we can conclude Yt ≥ 0 for all t ∈ [0, T ], and hence V ab ≥ V a + V b .

C Proof of Proposition 3

Consider the case of y 1 ≥ y 2 . Let us deﬁne

∫t

= e− 0 (rs −ys )ds

1

ṼtF VtF (C.1)

∫t

− 0 (rs −ys )ds

1

ṼtG = e VtG , (C.2)

as well as ∫ ∫s

e− (ru −yu

1 )du

D̃t = 0 dDs (C.3)

]0,t]

[ ∫ ∫ ]

ṼtG

= E Q

− ηs1,2 max(ṼsG , 0)ds + dD̃s Gt (C.4)

]t,T ] ]t,T ]

[ ∫ ∫ ]

ṼtF = E Q

− 1,2 F

ηs max(Ṽs , 0)ds + dD̃s Ft . (C.5)

]t,T ] ]t,T ]

Ut = E Q ṼtG Ft . (C.6)

28

Then, using Jensen’s inequality, we have

[ ∫ ∫ ]

Ut ≤ E Q

− 1,2

ηs max(Us , 0)ds + dD̃s Ft . (C.7)

]t,T ] ]t,T ]

Therefore, we obtain

[ ∫ ]

( )

ṼtF − Ut ≥ E Q

− ηs1,2 max(ṼsF , 0)− max(Us , 0) ds Ft (C.8)

]t,T ]

[ ∫ ]

≥ E Q

− ηs1,2 ṼsF − Us ds Ft . (C.9)

]t,T ]

Using the stochastic Gronwall-Bellman Inequality as before, one can conclude that ṼtF ≥

Ut for all t ∈ [0, T ], and in particular, V0F ≥ V0G .

In order to get clear image for the reliability of Gateaux derivative, we compare it with the

numerical result directly obtained from PDE. We consider a simpliﬁed setup where MtM-

CCOIS exchanges the coupons continuously, and the only stochastic variable is a spread

y. Consider continuous payment (i, j)-MtMCCOIS where the leg of currency (i) needs

notional refreshments. We assume following situation as the asymmetric collateralization:

(1) Party 1 is the basis spread payer and can use either the currency (i) or (j) as collateral.

(2) Party 2 is the basis spread receiver and can only use the currency (i) as collateral.

In this case, one can see that the value of t-start T -maturing contract from the view

point of party 1 is given by (See, Eq. (6.19).)

[∫ T ( ∫ s )( ) ]

Vt = E Q(j)

exp − R(u, Vu )du ys − B ds Ft ,

(j,i)

(D.1)

t t

where ( )

(j,i) (j,i)

R(t, Vt ) = c(j) (t) + yt + max −yt , 0 1{Vt <0} (D.2)

and B is a ﬁxed spread for the contract. y (j,i) is the only stochastic variable and its

dynamics is assumed to be given by the following Hull-White model:

( ) (j)

(j,i) (j,i)

dyt = θ(j,i) (t) − κ(j,i) yt dt + σy(j,i) dWtQ . (D.3)

Here, θ(j,i) (t) is a deterministic function speciﬁed by the initial term structure of y (j,i) ,

(j,i) (j)

κ(j,i) and σy are constants. W Q is a Brownian motion under the spot martingale

measure of currency (j).

The PDE for Vt is given by

( ( (j,i) )2 )

∂ ∂V (t, y) σy ∂2 ( )

V (t, y) + γ(t, y) + 2

V (t, y) − R t, V (t, y) V (t, y) + y − B = 0 ,

∂t ∂y 2 ∂y

(D.4)

29

where

γ(t, y) = θ(j,i) (t) − κ(j,i) y . (D.5)

If party 1 is a spread receiver, we need to change y − B to B − y, of course.

Terminal boundary condition is trivially given by V (T, ·) = 0. On the lower boundary

of y or when y = −M (= ymin ) ≪ 0, we have Vt < 0 for all t. Thus, we have R(s, V (s, y)) =

c(j) (s) for all s ≥ t, if y = −M at time t. Therefore, on the lower boundary, the value of

MtMCCOIS is given by

[∫ T ]

∫ (j) (j,i)

V (t, −M ) = E Q(j)

e− ts cu du (j,i)

(ys − B)ds yt = −M

t

∫ T ( )

∂

= D (t, s) −B −

(j)

ln Y (j,i)

(t, s) ds . (D.6)

t ∂s

Since c(j) (t) is a deterministic function, D(j) (t, s) = D(j) (0, s)/D(j) (0, t) is simply given

by the forward.

On the other hand, when y = M (= ymax ) ≫ 0, we have Vt > 0 for all t. Thus we

have R(s, V (s, y)) = c(j) (s) + y (j,i) (s) for all s ≥ t, if y = M at time t. Thus, on the upper

boundary, the value of the contract becomes

[∫ T ∫ ( (j) (j,i) ) ( ) ]

Q(j) − ts cu +yu du (j,i)

V (t, M ) = E e ys − B yt = M

(j,i)

t

∫ T{ }

∂ (j,i)

= −BD (t, s)Y

(j) (j,i)

(t, s) − D (t, s) Y

(j)

(t, s) ds . (D.7)

t ∂s

Now let us compare the numerical result between Gateaux derivative and PDE. In the

case of Gateaux derivative, the contract value is approximated as

( )

Vt ≃ Vt (0) + ∇Vt 0; max(−y (j,i) , 0) , (D.8)

[∫ ) ]

where

T ∫s (

ys − B ds Ft ,

(j) (j,i)

Q(j) − (cu +yu )du (j,i)

Vt (0) = E e t (D.9)

t

and

( )

∇Vt 0; max(−y (j,i) , 0)

[∫ T ]

∫ ( ) ( (j,i) )

max −Vs (0), 0 max −ys , 0 ds Ft . (D.10)

(j) (j,i)

Q(j) − ts (cu +yu )du

=E e

t

Vt (0) is the value of the contract under symmetric collateralization where both parties

post currency (i) as collateral, and ∇Vt is a deviation from it.

In Fig. 6, we plot the price diﬀerence of continuous 10y-MtMCCOIS from its symmetric

limit obtained by PDE and Gateaux derivative with various volatility of y (j,i) . Term

structures of y (j,i) and other curves are given in Appendix E. Here, the spread B is chosen

in such a way that the swap price is zero in the case where both parties can only use

currency (i) as collateral, or B is a market par spread. The price diﬀerence is Vt − Vt (0)

and expressed as basis points of notional. From our analysis using the recent historical

30

data in Ref. [10], we know that the annualized volatility of y is around 50 bps for a calm

market but it can be more than (100 ∼ 200) bps when CCS market is volatile (We have

used EUR/USD and USD/JPY pairs.). One observes that Gateaux derivative provides

reasonable approximation for wide range of volatility. If the party 1 is a spread receiver,

both of the methods give very small price diﬀerences, less than 1bp of notional.

The parameter we have used in simulation are

σc(j) = σc(i) = 1% (E.2)

σx(j,i) = 12% . (E.3)

All of them are deﬁned in annualized term. The volatility of y (j,i) is speciﬁed in the main

text in each numerical analysis.

Term structures and correlation used in simulation are given in Fig. 7. There we have

deﬁned

1 [ ∫ T (k) ]

e− 0 cs ds

(k) (k)

ROIS (T ) = − ln E Q

T

1 [ ∫ T (j,i) ]

e− 0 ys ds .

(j)

Ry(j,i) (T ) = − ln E Q

T

The curve data is based on the calibration result of typical JPY and USD market data

of early 2010. In Monte Carlo simulation, in order to reduce simulation error, we have

adjusted drift terms θ(t) to achieve exact match to the relevant forwards in each time step.

31

Figure 1: Price diﬀerence from symmetric limit for 10y MtMCCOIS

32

Figure 3: Price diﬀerence from symmetric limit for 10y OIS

33

(j)

Figure 5: Price diﬀerence from symmetric limit for 20y OIS for the change of σc

Figure 6: Price diﬀerence from symmetric limit for 10y continuous MtMCCOIS

34

Figure 7: Term structures and correlation used for simulation

35

References

[1] Assefa, S., Bielecki, T., Crepey, S., Jeanblanc, M., 2009, ”CVA computation for

counterparty risk assessment in credit portfolios”.

[2] Brigo, D. , Morini, M., 2010, ”Dangers of Bilateral Counterparty Risk: the funda-

mental impact of closeout conventions”, available at arXiv.

[3] Duﬃe, D., Huang, M., 1996, ”Swap Rates and Credit Quality,” Journal of Finance,

Vol. 51, No. 3, 921.

[4] Durrie, D., Epstein, L.G. (appendix with Skiadas, C.), 1992, ”Stochastic Diﬀerential

Utility,” Econometrica 60: 353-394.

[5] Duﬃe, D., Skiadas, C., 1994, ”Continuous-time security pricing: A utility gradient

approach,” Journal of Mathematical Economics 23: 107-131.

[6] Feldhütter, P., Lando, D., 2008, ”Decomposing swap spreads, ” Journal of Financial

Economics, 88(2), 375-405.

[7] Fujii, M., Shimada, Y., Takahashi, A., 2009, ”A note on construction of multiple swap

curves with and without collateral,” CARF Working Paper Series F-154, available at

http://ssrn.com/abstract=1440633.

[8] Fujii, M., Shimada, Y., Takahashi, A., 2009, ”A Market Model of Interest Rates with

Dynamic Basis Spreads in the presence of Collateral and Multiple Currencies”, CARF

Working Paper Series F-196, available at http://ssrn.com/abstract=1520618.

[9] Fujii, M., Takahashi, A., 2010, ”Modeling of Interest Rate Term Structures under

Collateralization and its Implications.” Forthcoming in Proceedings of KIER-TMU

International Workshop on Financial Engineering, 2010.

[10] Fujii, M., Takahashi, A., 2011, ”Choice of Collateral Currency”, Risk Magazine, Jan.,

2011: 120-125.

http://www.isda.org/c and a/pdf/ISDA-Margin-Survey-2010.pdf Market Review of

OTC Derivative Bilateral Collateralization Practices,

http://www.isda.org/c and a/pdf/Collateral-Market-Review.pdf

ISDA Margin Survey 2009,

http://www.isda.org/c and a/pdf/ISDA-Margin-Survey-2009.pdf

[12] Johannes, M. and Sundaresan, S., 2007, ”The Impact of Collateralization on Swap

Rates”, Journal of Finance 62, 383410.

[13] Piterbarg, V. , 2010, ”Funding beyond discounting : collateral agreements and deriva-

tives pricing” Risk Magazine.

[14] ”Dealers face funding time-bomb from one-way CSAs”, the article of RISK.net (2011,

Feb).

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